While prices of products coming out of Chinese factories are not falling as fast as the price of shares of the Shanghai Stock Exchange, they have been falling for much longer, they show no signs of ending this trend and are actually causing much more pain in the real economy today than the gyrations of the stock market.
Factory prices in China have been falling now for nearly 4 years. The most recent number, for June 2015, showed an annualized pace of decline of 4.8% Keep that up for a few years and unless you change your business model or your raw materials and other inputs show equally rapid decline in prices you will find your profits disappearing faster than the wine at a Chinese banquet. And indeed in some industries that is the case today.
The root cause is an overshoot in capacity. As growth in domestic and export demand slowed, too many companies were showered with capital and they spent it building more capacity. This behavior was almost inevitable given the land grab mentality of many private sector and state owned enterprise entrepreneurs. If you don’t get to #1 by size and then stay there, what chance would you have of winning in the long term – this was the mantra of many. As provinces competed with each other to be home to the winner, they contributed to the over capacity by encouraging and even financing their local champion to overinvest.
So what are China’s entrepreneurs doing when faced with this?
The weak, the slow, the inflexible who are unable to adapt and change at pace at undergoing a slow decline. Continuous belt tightening and cost cutting, failed attempts at diversification, using capital to keep the business going rather than to expand capacity. However they tend not to disappear, they still produce, often using marginal prices to sell their output, sustaining the downward pressure on prices. This remains the largest segment of companies.
The adapters embrace change and in particular are embracing functional expertise as a way to change their game, genuinely reducing costs and enhancing speed to market. Historically, many Chinese companies have simply ignored the potential of operational excellence to improve efficiency. Today the best are looking at everything from getting more out of their existing capacity in the factory, tightening up supply chains, improving energy, water, heat efficiencies through a more scientific approach. We are seeing 20-30% improvements, so poor have prior operations been. It is not just in operations that we see the change. It is also true in information technology, where Chinese companies typically underspent their international peers by 50%. Using IT to further enhance operations, to get faster and better customer insights and to work more effectively with suppliers are hallmarks of these adaptive companies. Finally, a more scientific approach to marketing is generating superior insights and greater impact. Often by working closely with China’s largest internet companies, adapters are getting a level of instant insight on actual and potential customers that they have never had before.
These companies are the ones that we should worry about as the next wave of competition from China. They already produced a good enough (and sometimes very good) quality of product. But multinationals often could win against them through their superior functional expertise that delivered better value to the customer. As Chinese entrepreneurs finally master excellence from marketing to IT to operations they become much more threatening competitors both in China and beyond. These companies have always believed in change, in reinvention and this is simply the next change in their journey.
Others, the immediate internationalizers, have simply sought to continue to grow by applying the techniques that applied successfully in China abroad. They put their China product into international markets and see what works and what does not. They tend not to realize that the damage that a poor first impression can make in more mature markets, that customers are much less willing to give a second or third chance to a manufacturer who disappoints them the first time round.
Slowly this downward pressure on prices is changing Chinese companies for the better. The winners are completing their evolution to world class on all key dimensions and are becoming ready to be threats to multinationals anywhere in the world, not just China. There are though two major transitional side effects. One is that we will continue to see marginal product exported from China that will continue to hold back the “Made in China” brand. The second is that there will inevitably be loss of jobs in China. Even the best companies may need fewer people as they become more efficient and the poorer performers will gradually downsize to reduce their costs.
Great pain across the board but its an economy wide case of “what doesn’t kill you will make you stronger”. Silently there will be many of the former and much more noisily a few of the latter.